The US is going up the down staircase

Outlook:

Whatever else is happening in the world, attention will be distracted until after the Fed statement and Yellen press conference this afternoon. The market has been led to expect a change in forward guidance away from “considerable period” in favor of some other language that will probably be even worse in terms of vagueness. But sometimes change is good in its own right. No one expects Yellen to announce anything earth-shaking and that leaves the Fed staff economic projections and the dots, the chart on which each Fed member places rate change forecasts. At a guess, they will cluster closer together this time and the bond gang will get in line. Whether that results in a more stable yield curve is another matter.

The problem is that the Fed does not and arguably cannot factor in disorderly conditions in other markets whether at home or abroad, even though those conditions do heavily influence the bond market. The Fed feels it has to view oil prices as a temporary aberration and the Russian intervention (selling dollars) has no meaning. It’s conceivable that the Fed knows about whatever QE the ECB will be initiating after the Jan 22 policy meeting, but again, the Fed doesn’t make policy in the context of other economies or other central banks. The few times the Fed tried to do that, starting with the Plaza Accord, it backfired big time.

The Fed’s single-minded focus on its limited mandate of inflation and employment leaves out the Fed’s original purpose and one of the original mandates—to maintain financial stability. Everyone forgets this aspect of the Fed, including, apparently, the Fed. As far as we know, the financial stability mandate was never removed. Greenspan didn’t like it and famously said no one, even the Fed, is not qualified to identify when a bubble is a bubble. Greenspan looked at equities but ignored the Thai crisis that ended up leading to contagion to Argentina and Russia and thence to Long-Term Capital—and the need to engineer a backroom rescue of LTCM. Bernanke followed suit and ignored the housing bubble and ensuing mortgage crisis (although then-member Mishkin noted the severity of the issue at Jackson Hole in 2008).

So, is Yellen ignoring oil and Russia at peril of another crisis whose dimensions we don’t yet know? Yeah, probably. This is the context in which today’s Events overshadow the Fed and any stance we can reasonably expect the Fed to take. And what would we have the Fed do to counter the coming crisis—buy oil to stabilize the price? Reach out to Putin? Objections to the Fed interfering in this way are obvious.

In fact, Pres Obama is set to sign a bill passed just last Saturday increasing sanctions against Russia. Ac-cording to the FT, “The most immediate impact of the legislation is to require the Obama administration to impose sanctions on Rosoboronexport, the main Russian state arms exporter. The company has been kept off previous sanctions lists, in part because of its role in supplying helicopters to Afghanistan. Un-der the bill, the Obama administration will have to impose sanctions on Gazprom if it significantly re-duces the flow of gas to Ukraine, Georgia, Moldova or Nato countries. It also authorises the sending of $350m of military aid to Ukraine, including anti-tank weapons — an issue that has been the subject of intense dispute with the administration but which Mr Obama has so far blocked because of fears that it could provoke an even more aggressive response from Russia.”

By forcing the central bank to fund Rosneft, critics say, Russia shows where its real interest lies—in the oligarchs, not the average Ivan. And yet Putin has an approval rating over 80% (if we believe Russian polls). The Russian budget is ridiculous, based on forecasts of growth and oil prices now hopeless of achievement. And yet we are not seeing any corrective action, just intervention. No one knows what will come next. We have read or seen a dozen interviews with experts—no one knows. It’s a big black cloud hanging over the world.

And when it comes to irrational, testosterone-addled state actions, North Korea is supposed to be behind the hacking at Sony and starting an international “incident” over a movie, purportedly a comedy, that involves the assassination of the N. Korean leader. A book just came out to numerous reviews stating that students at N. Korea’s equivalent of MIT were unaware of the internet’s existence, so how N. Korea could have developed advanced hackers in a few months is a mystery. But Sony is cancelling showing the movie because movie theater chains won’t take it, out of fear of reprisal.

The incident means almost nothing but shows that everyone is living in a state of fear and dread over what awful thing can come next. The bottom line is that dread feeds safe-haven sentiment. The Japanese are a good barometer of fear and sure enough, dollar/yen hit 115.55 overnight—from 122.65 at end-November. Several forecasters have named 115 as the dollar target, but experience tells us that the yen can go anywhere it wants to, little fettered by preconceptions (or important chart points). Emerging market currencies are already stressed and if the Fed delivers today, likely to see additional selling.

As you can probably tell, we don’t hold out much hope of a lasting dollar rally on the Fed. The US is going up the down staircase. To a large extent, the US is independent of events in the rest of the global economy, so the Fed is “right” to ride its own horse. But we do expect some Events to emerge that will impress the bond boys and drive the yield back to 1.85% or worse. With investment managers favoring the euro and European equities on the coming QE, the dollar has only “growth” for support. As we have seen in the past, in the absence of inflation, growth is nice but does not suffice. Keep your powder dry until we get a clearer picture.

Note to Readers: Analysts have been saying for a few days they already see the market thinning out. Next week is Christmas week, with Christmas on Thursday. It’s dangerous to make decisions when the market is thin and flaky, so we are thinking of publishing reports on Monday but then not again until the following Monday. Comments and requests from readers are welcome.